Shorting Index Futures Options

Atlanta Technical Analysts Society

Re-Visiting “ Profits & Probabilities
Shorting Futures Options©“
(One Year Later)
In Volatile Markets
Eric Hartford
american_eric@hotmail.com
2 July 2008

Disclaimer – The markets are an expensive place to learn. Don’t even think
about trading with money that you cannot afford to lose; in fact, kiss off your
entire trading account before your first trade- it’s gone! What were you thinking?
All trading systems involve losses. Past performance means nothing. Don’t
believe anything you can’t prove. Eric Hartford is not a registered security
representative nor financial advisor, bears no responsibility for you or your
actions, has obvious trust issues, and laughs at; efficient market theory,
bipartisan commissions, soft landings, mutual funds, dollar cost averaging, self-
regulation, the SEC, buy and hold, corporate integrity, BLS statistics, CPI
calculation, petroleum reserve estimates, re-stated earnings, & the Laffer Curve.
Of course, the market is rigged against you, but you can’t win if you don’t try.

Last Year

• A Complete Trading System
– Short Index Futures Options
– Scalable
• Rules – Position Sizing, Heuristics
• Entry – 4 ways to figure Probability
• S&P 500 Digression
– 3 charting packages
• Expectancy - Profitability
• Exit – 8 ways out of credit spread stress
Creative Destruction Company
All Rights Reserved 2

System Elements

• Underlying
• Pit traded Options on S&P 500 Futures
-
– Favorable margin (SPAN)
– Favorable taxation 60:40 Long Term Short Term
Cap Gains
– Favorable liquidity at strikes far out-of-the-
money
• Trade Duration
– 5 – 10 Weeks before expiration
• Position Sizing
– 1 short strangle/condor per $5K margin
– 10% Value at risk requires exit at twice
premium collected, per side
• Entry
– Premium writing, short strangles, iron condor
• Exits
– 8 techniques for positions under pressure


Strangling the S&P 500

• Write premium on 20-pt credit
spreads
– Both puts and calls,
– Legging in – better fills, higher risk
of no fill
• Short OTM option strikes
– Probability < ~ 10% finishing ITM
– Probability < ~ 20% contacting
– Minimum range based on volatility,
duration
• 45% minimum annualized return
initially

Trade Vehicles vs. Leverage

• SPY (I Share) 1 S&P 500 pt approx = $0.10

• $SPX (CBOE Index) 1 S&P 500 pt = $1.00

• ES-U07 (e-mini) 1 S&P 500 Future pt = $50.00

• SP07 (CME Full) 1 S&P 500 Future pt = $250.00
• EV07 (End of Month) S&P 500 Fut pt = $250.00
&
• OPTIONS on all of above


Range vs. Duration & Volatility

Time to Expiration ~ weeks

VIX 5 6 7 8 9 10

NT 150 160 170 180 190
10

145 155 165 175 185 195
12

180 190 200 210 220 NT
14

210 210 220 225 NT NT
16

Wait for reversal before selling puts
>18


Other Considerations

• Frequency
– Rate trading opportunities occur is generally 1 per day
– Conditions change, but generally can initiate 60%
annualized return trade when VIX is over 14.5

• Reliability
– Only matters wrt Expectancy & to Trader’s personality,
goals
– As you’ll see in Expectancy, generally 83% of trades win

• Costs
– Commission/fee is $16.65 round turn on full CME S&P 500
– Psyche tested often, Bid/Ask widens from 0.20 pts to 2.00
pts
– Opportunity – entry during low volatility foregoes better
returns later


Heuristics ~ Rules of Thumb

• 5 pt move in the S&P futures fills at net
settlement in the direction of the move

• Collect >one point on put & call spreads
– Puts typically 4 pts short, 3 pts long
– Calls typically 2 pts short, 1 pt long
– 8.7% initial net on maximum exposure
– 90% initial annualized for 35 days,
45% at 70 days

• Enter trades in multiples of 2, 3, 4, 6

• Generally 12 – 24 positions per expiration
cycle

Probability Finishing ITM
vs.
“Touching” before expiry

• Standard Deviation – I use 1.6 std dev
– IV ATM Call x underlying x sq rt DTE/365
– (ATM Put + ATM Call) x 1.25
• Log Normal – see formula on handout
• Delta is + or – 3% approximation for:
Volatility< 50
Time to expiration < 70 days
• Monte Carlo Simulation


Option Greeks – Futuresource.com

Option Call Strike

Delta Gamma Theta Vega Last

SPQ07 0.359 0.006 32 181 15.40 1550
0.291 0.006 28 166 10.80 1560

0.247 0.005 26 153 9.00 1570

0.184 0.005 21 129 5.80 1580

0.143 0.004 18 109 4.20 1590

0.097 0.003 13 83 2.50 1600

0.068 0.002 10 63 1.60 1610

0.046 0.002 7 47 1.00 1620

0.030 0.001 5 33 0.60 1630

0.016 0.001 3 20 0.30 1640

0.013 0.001 2 17 0.25 1650

0.008 0 2 11 0.15 1660

0.010 0 2 13 0.20 1670

McMillan Monte Carlo Simulator
Probabilities

Historical Volatility: 13.07

JULY (10) AUGUST (38) SEPT (72)
CALLS
1670 3 11
1660 4 13
1650 6 15
1640 1 7 18
1630 1 9 22
1620 1 12 25
1610 1 16 31
1600 2 21 35
1590 4 26 41
1580 7 33 47
1570 12 41 53
1560 20 48 61
1555 25 54 64


Other Entry
Considerations

• Support and Resistance
• Fibonacci Levels
• Andrews Pitchforks & Channels
• Daily Pivot limits for order pricing
• Degree & Duration of Trends
• Average True Range, Rate of
Change
• 20-, 50-, 200-Day, Trend Support
MAs
• And now, a digression on the S&P
w/charts…

Expectancy

Expectancy =
%wins x avg. win – %losers x avg. loss
Actual results
$262 = 0.83 x $464 – 0.17 x $723

• Theoretical Expectancy
– For credit spread systems
Probabilityw (Credit) – ProbabilityL (Loss Limit)
• Theory is not Fact
– Market distributions have fat tails
• Summation of 300+ trades over the last 24
months
• POSITIVE EXPECTANCY DEFINES A
WINNING SYSTEM !

Profit

• Nearly 800 trades
• From Aug 03 – June 07

• Not using CAGR- uncompounded

2004 – 63% annualized returns

• Expectancy based on rolling 24 month results
-
of 40.7% annualized returns


Exit Guidelines

• Close position if;
– Underlying crosses strike intraday
– Delta exceeds 0.400
– McMillan probability exceeds 75%
– Annualized return remaining < new
position
-Typically 85% target reached w/ > 20
DTE
– Expiration
• Strong Move right after entry =
worst case


8 Exits for Stressed Spreads

1) Do nothing
2) Exit to close

3) Roll away strikes same month
4) Roll out in time at same strike
5) Roll out and away

6) Jump in front with an options hedge
7) Jump in front with a futures hedge
8) Jump in front with synthetic futures


What has changed
since then?
• One year older ( wiser? )
• Existing Trends Extended
– Suburban Housing continues to lose value
– Energy Doubles – Demand exceeds Supply Q4
‘07
– Wars continue – millions of lives ruined
• $30 per capita/per month indefinitely
• Congress approves $300M to “prepare the
battle space” in Iran
– Growing Debt (Personal, Corp, Govt) destroys
Dollar and Banks
– Banks Reluctant to lend. Rinse, Repeat…
• Globalization continues
• Jobs dwindle – everyone’s a contractor
• Competition for Resources must price out
demand
• Per capita GDP shrinks Q4 ’07 and Q1 ‘08
• Market conditions … changed…


USA - Housing Index


Oil

• Supply Constant 3
year
86.6 MBD May 2005
86.7 MBD Jan 2008

•USA uses ~21 MBD

•Inventories declined
19.1MBD over 4
weeks below Aug ’05
levels

• Price out 5% USA
Demand?


USA Finance – Pre-Collapse or
Pre-TakeOff ?


US Dollar Index


So, what did I do about
all this?
• Read a couple books by Taleb
– Fooled by Randomness
– The Black Swan
• Coin Flip
• Returns – not normal, the past is no guide,
luck matters
• Absence of Proof is not Proof of Absence
• Fat Tails & 100 year floods and Marginal
Effects
• Narratives
• Quit trying to pick up all the nickels
in front of the steamroller, at least
not all…


What I did about what I learned

• Expanded the volatility/duration
– Traded Volatilities up to 24 on VIX
• Traded shorter durations
– Used new instrument – EoM Options
• Traded directionally
– Coin flip correlation
• Traded Broken Wing Condors
– Unbalanced, Long option NTM option
– Profit probability at exit before expiry


Constructing Condors


Results

• Got hammered last August
– Spent on long positions
– Went to bed deep ITM
– Fed intervention cost me 40 pts
• (@ $250 per)
• Closed out Jan put positions at a loss
- Got worse even faster than my
bearish view
- Rolling 12 month returns ~ 12 %
- Now buy options, new issues
- Timing, Profit Targets, Reward:Risk

THANKS !

Any Questions ?


Shorting Index Futures Options

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